Indexed Annuities: Growth Potential with Downside Protection

Indexed annuities (IAs) set a new annual sales record in 2018, due in part to higher interest rates that allowed insurance companies to offer more appealing income withdrawal rates.1 Of course, the fact that a product is popular doesn’t mean it’s right for you. Indexed annuities are complex, so it’s important to understand how they work and the options you may have if you decide to purchase an indexed annuity contract.

Minimum and Indexed Returns

Like all annuities, an indexed annuity is a contract with an insurance company that offers an income stream in return for one or more premium payments. Payments may begin right away (immediate annuity) or at a future date (deferred annuity) and are paid over the life of the contract, which might be the owner’s lifetime, the lifetimes of two people, or a specific number of years. Of course, any guarantees are contingent on the financial strength and claims-paying ability of the issuing insurance company.

An indexed annuity offers a minimum rate of return (typically 1% to 3%) with a potentially higher rate based on the performance of a specified market index, such as the S&P 500. If the market has a down year, you will receive at least the minimum return, contingent upon holding the IA until the end of the contractual term. If the market has an up year, you would receive a higher return, calculated in one or more of the following ways, based on the performance of the index.

Participation rate. Determines how much of the index gain will be credited to the annuity. For example, a participation rate of 80% means the annuity would be credited with only 80% of the gain experienced by the index.

Spread/margin/asset fee. May be assessed in addition to, or instead of, a participation rate. For example, if the index gained 10% and the spread/margin/asset fee is 2.5%, then the gain in the annuity would be only 7.5%.

Interest-rate cap. The maximum rate of interest the annuity will earn. For example, if the index gained 10% and the cap rate is 6%, the gain in the annuity would be 6%.

Index performance generally does not include dividends, and the way in which the performance is measured may vary, depending on the contract (see methods below). Participation rates, cap rates, and other fees are set by the insurance company, and some companies reserve the right to change these provisions either annually or at the start of each contract term. These types of changes could affect the investment return.

General Considerations

Most annuities have surrender charges that are assessed if the contract owner surrenders the annuity during the early years of the contract. However, some indexed annuities allow withdrawals of up to 10% per year without surrender charges. Of course, any withdrawals will reduce the principal, and withdrawals before the end of an index period will receive no interest for that period. Early withdrawals prior to age 59½ may be subject to a 10% federal income tax penalty.

Like all annuity contracts, indexed annuities have rules, restrictions, and expenses. Depending on the guarantees of the issuing company, it may be possible to lose money with this type of investment. Be sure to review the contract carefully before deciding whether to invest.

The S&P 500 index is an unmanaged group of securities that is widely recognized as representative of the U.S. stock market in general. You cannot invest directly in any index and do not actually own any shares of an index. Past performance is not a guarantee of future results.

Tax advice and accounting services are offered independently of Equity Services, Inc. (ESI). ESI, and any companies affiliated with ESI, are not sponsoring, are not responsible for, and make no warranties or representations as to the CPA's right to or competence to practice accounting. Anyone dealing with the CPA assumes the entire risk of dealing with the CPA in connection with the practice of accounting or providing tax advice.

Dale Mullin and Robert A. Ricciardelli are Registered Representatives and Investment Adviser Representatives of Equity Services, Inc. and offer securities in NY. They are also insurance-licensed in NY.